“Fear Trade” Alert—Again

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We are in the midst of the Fear trade again today… and China is again the culprit. This time it’s not that country’s stock market, but its all-important manufacturing sector.

More evidence today that the market’s recent China-centric anxiety has been justified, with declines in two factory-sector purchasing managers surveys. The country’s official August manufacturing PMI fell to 49.7 from July’s 50. With a reading of 50 as the dividing line between expansion and contraction, today’s below-50 reading shows that the country’s factory sector is now in contraction territory. A separate PMI survey from Caixin Media and Markit also showed a similar reading in contractionary territory.

The ripple effects of China’s factory sector slowdown are showing up throughout Asia and elsewhere. The devaluation of the country’s currency had prompted some to entertain the notion that the state of China’s underlying economy may be even weaker than what came through in official data. The competitive challenge that the Chinese devaluation offered to the country’s trading partners has started showing up in trade data, as this morning’s -14.7% drop in South Korea’s August exports confirms. Other China-dependent regional economies like Japan, Australia and Indonesia are faced with a similar issue – the neighbor is dragging down everyone with it.

[See: The Fear Trade: Snake Oil Salesmen and the Dangers of Being Duped]

We have been stating in this space that the magnitude of US vulnerability to the Chinese slowdown is minimal, but that doesn’t mean there is no impact. There is plenty of negative drag, particularly in the US’s export-oriented manufacturing sector. We will likely see this in the August manufacturing ISM survey coming out a little later today. But the impact isn’t big enough to drag the entire economy is down, as is expected to be the case with Australia and others.

The key issues for US investors resulting from this Chinese situation are twofold: the impact it is having on stocks and what it does to the course of Fed policy in the coming days. The market impact is clear in the heightened market volatility (look at the sea of red on the screens this morning), but the Fed angle is less than obvious.

The lack of Fed clarity is largely a function of the disparate voices coming from members of the Federal Open Mouth Committee, as someone aptly called them some time back. I hope they don’t keep the ongoing market volatility from doing the right thing, which is to take the first step towards normalizing interest rate policy. They took interest rates to zero in the depth of the financial crisis when the US economy was literally in the trauma center.

One could argue how strong or otherwise the US economy is relative to its long-run potential, but no one can deny it is the strongest and most vibrant economy of all of its trading partners at present. It simply doesn’t need zero interest rates any longer.

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